Fear stalks the markets

Returning home late at night, I hunt out a luxury chocolate bar hidden in a cupboard. I’m not really hungry, and am far more likely to be thirsty after working in an air-conditioned office – so, rationally, I should just have a glass of water. But the chocolate always wins. I seem to have taken a risk (with my weight) that will lead to a certain loss (I will end up heavier).

Inadvertently, I may be playing out a behavioural tendency that Daniel Kahneman and Amos Tversky documented in 1979 in a paper titled “Prospect Theory”. In a nutshell, when people face a gain, they become risk adverse; when they face a loss, they become risk seeking. This goes some way to explaining why people buy houses, for example, in a rising property market but sell when prices fall. Rationally, it should be the other way round.

Could this type of behaviour pattern also be what we are seeing in the global financial crisis, and in Europe in particular?

The Eurozone crisis is far from over and appears to be deteriorating as investors take fright amid fears of contagion in the region. Greece is running out of money. Italy, Spain, Belgium and France are all looking to refinance bonds. Even Germany, the powerhouse of Europe, is not immune, as was seen when its bond auction failed recently.

In the US, politicians are in a stalemate over a plan to cut the nation’s deficit, with a failure to agree to reduce spending and/or tax the rich.

Our political leaders do not seem to know how to get us out of this fix and appear to be taking a risk with the health of our economies by failing to agree on what measures to take. The markets, on the other hand, may be seeing the return of the cautious investor, whose gambling days are over for now. They are not wishing to invest in countries that are heavily indebted and in danger of a sovereign debt default.

Meanwhile, economic forecasters keep revising their growth forecasts downwards. It seems we can’t rely on even the so-called experts getting it right any more. So these uncertain times are making experts of us all, where the layman can feel the chill way before any economic model warns them worse is to come.

And so we see consumers becoming more cautious, more rational. In the UK they are reining in their expenditure and paying off their debt. It always seemed a bit irrational to buy goods on credit, racking up thousands of pounds in loans – money that couldn’t afford to be spent on goods that did not retain their value. But with concern rising over the performance of some national retail chains, it is rational for the government to urge the public to spend their way out of the crisis. If shoppers are not spending, stores will ultimately close, with further job losses. On the other hand, though, we’re being told we need to save more for our pensions. Spend or save? Mixed messages are all a bit irrational.

If that wasn’t bad enough, the bankers are eyeing up their bonuses again despite the public blaming them for causing all of this in the first place. It appeared irrational for banks to lend to people who could not pay off the loans (the great recession has its roots in the US sub-prime mortgage crisis), except, of course, some made millions in fees from these transactions at the time. Now, though, lenders have returned to a more cautious stance and tightened credit conditions. The trouble is that’s bad for business and job creation.

There’s only one thing for it: stock up on more chocolate. It may not appear rational, but at least that investment will make you feel better.﻿

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